Banking on It - February 2008

Smooth Sailing with Financial Lenders

Understanding the Five Cs of Credit

by Bruce Ford

Whether a business is seeking funds for working capital, equipment or inventory, construction, or for any other reason, a lender will assess credit worthiness based on five factors known as the “Five Cs of credit.”  These are:

1. Capacity to pay bills and repay the loan through a comparison of revenue against reoccurring debts;

2. Collateral as security for the loan;

3. Capital including assets the owner has invested in the company personally, because this commitment lessens the chance of defaulting on the loan;

4. Conditions of the loan, including the local and national economic climate for the industry, the purpose of the loan,the overall principal amount and interest rate; and

5. Character of the person requesting the loan based on their reputation and perceived trustworthiness, experience in business and industry, apparent viability of the business, and the credit history. On a commercial loan, both personal and business credit reports are relied on as a strong indicator of future payment performance.

Together, these elements reassure the lender that the company can repay the loan and that the additional debt load will not cripple cash flow or cause excessive financial stress for the business.

A solid understanding of the above “Five Cs” and attention to a business’s credit report before initiating the lending process positively impacts the outcome of loan requests. Discovery and repair of potential issues before beginning the loan process can be significantly faster than being declined the funding, then having to fix the issues and reapply for the loan.  

Even for businesses that aren’t actively seeking a loan, a credit rating should be closely monitored. Almost every business will require credit from its suppliers at some point. Those prospective suppliers usually check a credit report before extending credit terms and limits.  

Before You Apply

Before you apply for any type of credit or financing, there are a few basic requirements that must be in place. A new business must obtain all necessary licenses, registrations and permits for the city, county and state governments. Also, it should secure a Federal Tax ID Number or Employer Identification Number, which is akin to a business social security number. It is also important to register with a few business credit organizations, such as Dun & Bradstreet and the business divisions of Equifax, TransUnion and Experian.

Once basic accounts with vendors and suppliers have been established, it is critical to take care of those accounts diligently because they are the foundation of a business credit report. Ideally, before lenders are approached, an 18- to 24-month credit history should be established. However, if the owner has a strong personal credit history, the lack of a business history is not a barrier toward obtaining a loan.

Hidden Costs of Bad Credit

A negative credit report can manifest itself in unexpected ways far beyond just costing the business a higher interest rate and/or lower credit limit on debts. The cost of insurance premiums, for example, is usually higher when the insured is considered a higher risk. Contracts can be won or lost based on the credit report, since potential new clients and vendors may use it to judge financial stability or evaluate competitors.

It is important to regularly check credit reports for changes and accuracy, just as people do for their personal credit. If a business waits until it needs credit before repairing or rebuilding their credit report, it can significantly delay or halt the process, and the total financing cost can be drastically increased.   

Bruce Ford
Bruce Ford is chief operating officer of the Las Vegas-based holding company, Community Bancorp.